Lantronix 10Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to ___________.

Commission file number: 1-16027

LANTRONIX, INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0362767
(State or other jurisdiction	(I.R.S. Employer
of incorporation or organization)	Identification No.)

15353 Barranca Parkway, Irvine, California

(Address of principal executive offices)

92618

(Zip Code)

(949) 453-3990

(Registrant’s telephone number, including area code)

Former name, former address and former fiscal year, if changed since last report: N/A

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated Filer o

Accelerated filer o

Non-accelerated filer x.

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes o No x.

As of February 3, 2006, 59,043,230 shares of the Registrant’s common stock were outstanding.

LANTRONIX, INC.

FORM 10-Q

FOR THE FISCAL QUARTER ENDED

December 31, 2005

INDEX

		Page

PART I.	FINANCIAL INFORMATION	1

Item 1.	Financial Statements.	1

	Unaudited Condensed Consolidated Balance Sheets at December 31, 2005 and June 30, 2005	1

	Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months Ended
	December 31, 2005 and 2004	2

	Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended
	December 31, 2005 and 2004	3

	Notes to Unaudited Condensed Consolidated Financial Statements.	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	22

Item 4.	Controls and Procedures.	22

PART II.	OTHER INFORMATION	23

Item 1.	Legal Proceedings	23

Item 1A.	Risk Factors	23

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.	31

Item 3.	Defaults Upon Senior Securities	31

Item 4.	Submission of Matters to a Vote of Security Holders	31

Item 5.	Other Information	31

Item 6.	Exhibits	32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share and share data)

	December 31,			June 30,
ASSETS	2005			2005
Current assets:
Cash and cash equivalents	$	7,194		$	6,690
Marketable securities		97			85
Accounts receivable (net of allowance for doubtful accounts of
$68 and $158 at December 31, 2005 and June 30, 2005, respectively)		2,528			2,646
Inventories, net		6,624			6,828
Contract manufacturers' receivable (net of allowance of
$27 and $22 at December 31, 2005 and June 30, 2005, respectively)		899			711
Settlements recovery		14,350			1,200
Prepaid expenses and other current assets		1,351			1,055
Total current assets		33,043			19,215

Property and equipment, net		587			674
Goodwill		9,488			9,488
Purchased intangible assets, net		246			559
Officer loans (net of allowance of $4,470
at December 31, 2005 and June 30, 2005, respectively)		119			116
Other assets		33			65
Total assets	$	43,516		$	30,117

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	5,988		$	4,702
Accrued payroll and related expenses		1,459			1,296
Warranty reserve		972			1,248
Restructuring reserve		155			264
Accrued settlements		16,950			1,200
Other current liabilities		3,685			2,812
Total current liabilities		29,209			11,522
Other long-term liabilities		92			76
Long-term capital lease obligations		6			51

Commitments and contingencies

Stockholders' equity:
Preferred stock, $0.0001 par value; 5,000,000 shares authorized;
none issued and outstanding		-			-
Common stock, $0.0001 par value; 200,000,000 shares authorized;
59,035,938 and 58,790,413 shares issued and outstanding at
December 31, 2005 and June 30, 2005, respectively		6			6
Additional paid-in capital		181,923			181,264
Deferred compensation		-			(17	)
Accumulated deficit		(167,994	)		(163,082	)
Accumulated other comprehensive income		274			297
Total stockholders' equity		14,209			18,468
Total liabilities and stockholders' equity	$	43,516		$	30,117

See accompanying notes

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2005			2004			2005			2004
Net revenues (1)	$	12,955		$	12,908		$	25,195		$	23,953
Cost of revenues (2)(3)		6,336			6,652			12,436			12,140
Cost of revenues - share-based compensation		21			-			41			-
Gross profit		6,598			6,256			12,718			11,813
Operating expenses:
Selling, general and administrative (3)		6,057			6,628			11,962			13,428
Selling, general and administrative - share-based compensation		161			96			328			153
Research and development (3)		1,257			1,421			2,608			3,716
Research and development - share-based compensation		53			-			105			5
Amortization of purchased intangible assets		-			19			2			48
Restructuring recovery		-			-			(29	)		-
Litigation settlement costs		2,600			-			2,600			-
Total operating expenses		10,128			8,164			17,576			17,350
Loss from operations		(3,530	)		(1,908	)		(4,858	)		(5,537	)
Interest income, net		18			7			21			16
Other income (expense), net		(49	)		472			(59	)		542
Loss before income taxes		(3,561	)		(1,429	)		(4,896	)		(4,979	)
Provision for income taxes		10			109			16			170
Loss from continuing operations		(3,571	)		(1,538	)		(4,912	)		(5,149	)
Income from discontinued operations		-			-			-			56
Net loss	$	(3,571	)	$	(1,538	)	$	(4,912	)	$	(5,093	)

Basic and diluted income (loss) per share:
Loss from continuing operations	$	(0.06	)	$	(0.03	)	$	(0.08	)	$	(0.09	)
Income from discontinued operations		-			-			-			-
Basic and diluted net loss per share	$	(0.06	)	$	(0.03	)	$	(0.08	)	$	(0.09	)

Basic and diluted weighted-average shares		58,670			58,149			58,582			58,033

(1) Includes net revenues from related party	$	306		$	296		$	606		$	614

(2) Includes amortization of purchased intangible assets	$	223		$	364		$	520		$	729

(3) Excludes share-based compensation expense, which is presented separately by respective expense category.

See accompanying notes

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Six Months Ended
	December 31,
	2005			2004
Cash flows from operating activities:
Net loss	$	(4,912	)	$	(5,093	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities
Depreciation		220			391
Amortization of purchased intangible assets		520			777
Share-based compensation		474			158
Provision for doubtful accounts		(35	)		221
Provision for inventories		(109	)		(69	)
Litigation settlement costs		2,600			-
Restructuring recovery		(29	)		(56	)
Gain on disposal of fixed assets		(2	)		(2	)
Foreign currency transaction loss (gain)		77			(403	)
Changes in operating assets and liabilities:
Accounts receivable		153			(569	)
Inventories		313			630
Contract manufacturers' receivable		(188	)		229
Prepaid expenses and other current assets		(287	)		(1,007	)
Other assets		28			(5	)
Accounts payable		1,262			451
Warranty reserve		(276	)		40
Restructuring reserve		(80	)		(310	)
Other liabilities		899			1,019
Net cash provided by (used in) operating activities		628			(3,598	)
Cash flows from investing activities:
Purchases of property and equipment, net		(132	)		(79	)
Purchases of marketable securities		-			(1,000	)
Proceeds from sale of marketable securities		-			3,425
Net cash (used in) provided by investing activities		(132	)		2,346
Cash flows from financing activities:
Net proceeds from issuances of common stock		200			306
Payment of line of credit		-			(250	)
Payment of convertible note payable		-			(867	)
Payment on capital lease obligations		(79	)		-
Net cash provided by (used in) financing activities		121			(811	)
Effect of foreign exchange rate changes on cash		(113	)		541
Increase (decrease) in cash and cash equivalents		504			(1,522	)
Cash and cash equivalents at beginning of period		6,690			9,128
Cash and cash equivalents at end of period	$	7,194		$	7,606

See accompanying notes

LANTRONIX, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

1. Basis of Presentation

The condensed consolidated financial statements included herein are unaudited. They contain all normal recurring accruals and adjustments which, in the opinion of management, are necessary to present fairly the consolidated financial position of Lantronix, Inc. and its subsidiaries (collectively, the “Company”) at December 31, 2005, the consolidated results of its operations for the three and six months ended December 31, 2005 and 2004, and its cash flows for the six months ended December 31, 2005 and 2004. All intercompany accounts and transactions have been eliminated. It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the three and six months ended December 31, 2005 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

Certain amounts in the three and six months ended December 31, 2004 condensed consolidated financial statements have been reclassified to conform with the current three and six month fiscal presentation. During the fourth quarter of fiscal 2005, adjustments were identified that resulted in a restatement of certain amounts in the Company’s unaudited first and second quarters of fiscal 2005. Additional information on the adjustments is included in the Company’s Annual Report on Form 10-K.

These financial statements do not include certain footnotes and financial presentations normally required under generally accepted accounting principles. Therefore, they should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended June 30, 2005, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on September 28, 2005.

2. Net Loss per Share

Basic and diluted loss per share is calculated by dividing net loss by the weighted-average number of common shares outstanding during the year.

The following table presents the computation of net loss per share (in thousands, except per share data):

	Three Months Ended						Six Months Ended
	December 31,						December 31,
Numerator:	2005			2004			2005			2004
Loss from continuing operations	$	(3,571	)	$	(1,538	)	$	(4,912	)	$	(5,149	)
Income from discontinued operations		-			-			-			56
Net loss	$	(3,571	)	$	(1,538	)	$	(4,912	)	$	(5,093	)
Denominator:
Weighted-average shares outstanding		59,002			58,481			58,914			58,365
Less: Unvested common shares outstanding		(332	)		(332	)		(332	)		(332	)
Basic and diluted weighted-average shares		58,670			58,149			58,582			58,033

Basic and diluted loss per share from continuing operations	$	(0.06	)	$	(0.03	)	$	(0.08	)	$	(0.09	)
Basic and diluted income from discontinued operations		-			-			-			-
Basic and diluted net loss per share	$	(0.06	)	$	(0.03	)	$	(0.08	)	$	(0.09	)

The following table presents the common stock equivalents excluded from the diluted net loss per share calculation, because they were anti-dilutive as of such dates. These excluded common stock equivalents could be dilutive in the future.

Three Months Ended

Six Months Ended

December 31,

2005

2004

2005

2004

Common stock equivalents

1,403,127

3,685,176

1,255,727

3,834,195

3. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):

	December 31,			June 30,
	2005			2005

Raw materials	$	3,787		$	3,973
Finished goods		6,731			7,277
Inventory at distributors		1,362			1,181
		11,880			12,431
Reserve for excess and obsolete inventories		(5,256	)		(5,603	)
	$	6,624		$	6,828

4. Purchased Intangible Assets

The composition of purchased intangible assets is as follows (in thousands):

			December 31, 2005							June 30, 2005
	Useful
	Lives				Accumulated							Accumulated
	in Years		Gross		Amortization			Net		Gross		Amortization			Net

Existing technology		1 - 5	$	7,297	$	(7,051	)	$	246	$	7,090	$	(6,533	)	$	557
Tradename/trademark		5		32		(32	)		-		32		(30	)		2

Total			$	7,329	$	(7,083	)	$	246	$	7,122	$	(6,563	)	$	559

The unamortized balance of purchased intangible assets will be amortized to cost of revenues as follows (in thousands):

	2006		2007		Total

Amount remaining to be amortized	$	143	$	103	$	246

5. Restructuring Reserve

From the fiscal quarter ended March 31, 2002 through the fiscal quarter ended March 31, 2003, the Company implemented plans to restructure its operations to prioritize its initiatives around the growth area of its business, focus on profit contribution, reduce expenses and improve operating efficiency. These restructuring plans included a worldwide workforce reduction, consolidation of excess facilities and other charges. During the fiscal years ended June 30, 2004 and 2003, approximately 58 and 50 employees, respectively, were terminated across all of the Company’s business functions and geographic regions in connection with the restructuring plans.

We expect to pay the remaining balance of the restructuring reserve within the next twelve months. A summary of the activity in the restructuring reserve account, which relates to the consolidation of excess facilities is as follows (in thousands):

	Six Months Ended
	December 31, 2005

Beginning balance	$	264
Restructuring recovery		(29	)
Cash payments		(80	)
Ending balance	$	155

6. Warranty

Upon shipment to its customers, the Company provides for the estimated cost to repair or replace products to be returned under warranty. The Company’s products typically carry a one-to two-year warranty. In addition, certain products that were sold prior to August 2003 carry a five-year warranty. Although the Company engages in extensive product quality programs and processes, its warranty obligation is affected by product failure rates, use of materials or service delivery costs that differ from our estimates. As a result, additional warranty reserves could be required, which could reduce gross margins. Additionally, the Company sells extended warranty services, which extend the warranty period for an additional one to three years, depending upon the product.

The following table is a reconciliation of the changes to the product warranty liability for the periods presented (in thousands):

	Six Months Ended			Year Ended
	December 31,			June 30,
	2005			2005

Beginning balance	$	1,248		$	1,770
Charged to cost of revenues		(56	)		(88	)
Deductions		(220	)		(434	)
Ending balance	$	972		$	1,248

7. Income Taxes

The Company utilizes the liability method of accounting for income taxes. The following table shows the Company’s effective tax rates for the periods shown:

Three Months Ended

Six Months Ended

December 31,

2005

2004

2005

2004

Effective tax rate

The federal statutory rate was 34% for all periods. The difference between our effective tax rate and the federal statutory rate resulted primarily from the effect of our domestic losses recorded without a tax benefit, as well as the effect of foreign earnings taxed at rates differing from the federal statutory rate.

8. Bank Line of Credit and Debt

Our revolving credit line at June 30, 2005 was $3.0 million. As of June 30, 2005, we had no borrowings against this line of credit. We had however, used letters of credit available under the line of credit totaling approximately $480,000 in place of cash to fund deposits on leases, tax account deposits and security deposits. As a result, our available line of credit at June 30, 2005 was $2.5 million. Pursuant to the line of credit, we were restricted from paying any dividends. As of June 30, 2005, we were not in compliance with the quick ratio covenant as defined in the agreement. A waiver was granted by the bank during August 2005. The line of credit expired on July 22, 2005. We are in the process of obtaining a new line of credit.

The Company issued a two-year note during August 2002 in the principal amount of $867,000 in connection with its acquisition of Stallion Technologies PTY, LTD, accruing interest at a rate of 2.5% per annum. Interest expense related to the note totaled approximately $5,000 for the six months ended December 31, 2004. The notes were convertible into the Company’s common stock at any time, at the election of the holders, at a $5.00 conversion price. The notes were due and paid in August 2004, as the holders elected not to convert the notes into the Company’s common stock.

9. Share-Based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”). This Statement requires companies to expense the estimated fair value of stock options and similar equity instruments issued to employees over the requisite service period. SFAS 123R eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees if certain conditions were met. However, under APB 25 and related accounting guidance, the Company recognized compensation expense for in-the-money option grants to employees and employee stock options assumed by the Company in connection with its acquisitions of the businesses that previously employed those individuals. Additionally, the pro forma impact from recognition of the estimated fair value of stock options granted to employees has been disclosed in our footnotes as required under previous accounting rules.

Effective for the first quarter of fiscal 2006, we adopted SFAS 123R using the modified prospective method, which requires us to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS 123R.

The fair value concepts were not changed significantly in SFAS 123R; however, in adopting SFAS 123R, companies must choose among alternative valuation models and amortization assumptions. After assessing alternative valuation models and amortization assumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”) option-pricing formula and straight-line amortization of compensation expense over the requisite service period of the grant. We will reconsider use of this model if additional information becomes available in the future that indicates another model would be more appropriate for us, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), we were not required to estimate forfeitures in our expense calculation for the stock compensation pro forma footnote disclosure; however, SFAS 123R requires an estimate of forfeitures and upon adoption we changed our methodology to include an estimate of forfeitures. The adoption of SFAS 123R had no effect on cash flows from financing activities.

The following table illustrates (i) the impact of adopting SFAS 123R on loss before income taxes, net loss and basic and diluted loss per share and (ii) as if the Company had continued to account for share-based compensation under APB 25 (in thousands, except per share data):

	Three Months Ended						Six Months Ended
	December 31, 2005						December 31, 2005
	SFAS 123R			APB 25			SFAS 123R			APB 25
Loss before income taxes	$	(3,561	)	$	(3,332	)	$	(4,896	)	$	(4,433	)
Net loss	$	(3,571	)	$	(3,342	)	$	(4,912	)	$	(4,449	)
Basic and diluted net loss per share	$	(0.06	)	$	(0.06	)	$	(0.08	)	$	(0.08	)

The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock option plans. For purposes of this pro forma disclosure, the fair value of the options is estimated using a BSM option-pricing formula and amortized on a straight-line basis to expense over the options’ vesting period (in thousands, except per share data):

	Three Months Ended			Six Months Ended
	December 31,			December 31,
	2004			2004

Net loss - as reported	$	(1,538	)	$	(5,093	)
Add: Share-based employee compensation expense included
in net loss, net of related tax effects - as reported		96			158
Deduct: Share-based employee compensation expense determined
under fair value method, net of related tax effects - pro forma		(370	)		(816	)
Net loss - pro forma	$	(1,812	)	$	(5,751	)
Basic and diluted net loss per share - as reported	$	(0.03	)	$	(0.09	)
Basic and diluted net loss per share - pro forma	$	(0.03	)	$	(0.10	)

Share Option Plans

The Company has in effect several share-based plans under which non-qualified and incentive stock options have been granted to employees, non-employees and board members. The Company also has an employee stock purchase plan for all eligible employees. The Board of Directors determines eligibility, vesting schedules and exercise prices for options granted under the plans. We issue new shares to satisfy stock option exercises and stock purchases under our share-based plans. No income tax benefit was realized from activity in our share-based plans during the three and six months ended fiscal 2006 and 2005.

A summary of the shares reserved for grant and options available for grant under each plan is as follows:

	December 31, 2005
	Shares		Options
	Reserved		Available
	for Grant		for Grant
1993 Incentive Stock Option Plan		4,000,000		-
1994 Non-statutory Stock Option Plan		10,000,000		-
2000 Stock Plan (“2000 Plan”)		10,000,000		4,671,215
2000 Employee Stock Purchase Plan (“ESPP”)		2,250,000		524,587
		26,250,000		5,195,802

Under the 2000 Plan, the number of shares available for issuance may be increased annually on the first day of the calendar year by an amount of shares equal to the lesser of (i) 2,000,000 shares, (ii) 5% of the outstanding shares on such date or (iii) a lesser amount as determined by the Board of the Directors. Each board member is automatically granted an option to purchase 25,000 shares of common stock following each annual meeting of stockholders, subject to certain eligibility requirements. As a result of the Company’s acquisitions, the Company assumed stock options granted under stock option plans established by each acquired company; no additional options will be granted under those plans. Option awards are generally granted with an exercise price equal to the market price of the Company’s stock at the date of grant. Option awards generally have a term of 10 years and vest and become exercisable over a three- to four-year service period.

The fair value of each share-based award is estimated on the grant date using the BSM option-pricing formula. Expected volatilities are based on the historical volatility of the Company’s stock price. The expected term of options granted subsequent to the adoption of SFAS 123R is derived using the simplified method as defined in the SEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury interest rates in effect at the time of grant. The fair value of options granted was estimated using the following weighted-average assumptions:

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2005		2004		2005		2004
Expected term (in years)		6.08		4.00		6.11		4.00
Expected volatility		94.55		99.36		94.68		99.44
Risk-free interest rate		4.45%		3.41%		4.39%		3.40%
Dividend yield		0.00%		0.00%		0.00%		0.00%

A summary of option activity under the stock option plans and changes during the quarter then ended is presented below (in thousands, except per share data):

	December 31, 2005
				Weighted-Average
						Remaining		Aggregate
				Exercise		Contractual		Intrinsic
	Shares			Price		Term		Value
Outstanding at beginning of period		5,084,110		$	1.49
Granted		180,100			1.47
Cancelled/forfeited		(325,673	)		1.72
Exercised		(115,974	)		0.76
Outstanding at end of period		4,822,563		$	1.49		7.3	$	2,709
Options exercisable at end of period		2,892,771		$	1.70		6.5	$	1,761

A summary of the grant-date fair value and intrinsic value information is as follows (in thousands, except per share data):

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2005		2004		2005		2004
Weighted-average grant-date fair value per share	$	1.17	$	0.68	$	1.16	$	0.68
Intrinsic value of options exercised	$	57	$	24	$	80	$	41
Intrinsic value of ESPP shares on purchase date	$	60	$	90	$	60	$	90

A summary of the activity of the Company’s nonvested shares is presented below (in thousands, except share and per share data):


				Weighted-Average				Remaining
						Remaining		Unrecognized
				Grant-Date		Years		Compensation
	Shares			Fair Value		To Vest		Cost
Nonvested outstanding at beginning of period		2,296,938		$	0.81
Granted		180,100			1.16
Vested		(402,693	)		0.77
Forfeited		(144,553	)		0.93
Nonvested outstanding at end of period		1,929,792		$	0.84		2.5	$	1,420

Employee Stock Purchase Plan

The number of shares available for issuance may be increased annually on the first day of the Company’s fiscal year in an amount equal to the lesser of (i) 150,000 shares, (ii) 2% of the outstanding shares on such date or (iii) a lesser amount as determined by the Board of Directors. Under the ESPP plan, each eligible employee may purchase common stock at each semi-annual purchase date (the last business day of February and August each year), but not more than 15% of the participant’s compensation, as defined. The purchase payable per share will be equal to eighty-five percent (85%) of the lower of (i) the closing selling price per share of common stock on the employee’s entry date into the two-year offering period in which that semi-annual purchase date occurs and (ii) the closing selling price per share of common stock on the semi-annual purchase date. Participants may discontinue their participation in the ESPP or may increase or decrease the rate of their payroll deductions during the ESPP offering period. The fair value of ESPP shares granted during the three and six months ended December 31, 2005 was estimated using the BSM option-pricing formula with an expected term (in years) of 0.5 to 2.0, expected volatility of 0.95, risk-free interest rate of 3.9% and dividend yield of zero. For ESPP shares granted during the three and six months ended December 31, 2004, we measured share-based compensation expense in our pro forma disclosure using the intrinsic value method as described in SFAS 123.

10. Comprehensive Loss

The components of comprehensive loss are as follows (in thousands):

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2005			2004			2005			2004

Net loss	$	(3,571	)	$	(1,538	)	$	(4,912	)	$	(5,093	)
Other comprehensive income (loss):
Change in net unrealized income on investment, net of taxes of $0		5			-			12			-
Change in accumulated translation adjustments, net of taxes of $0		(30	)		114			(35	)		134
Total comprehensive loss	$	(3,596	)	$	(1,424	)	$	(4,935	)	$	(4,959	)

11. Litigation

Government Investigation

The Securities and Exchange Commission is conducting a formal investigation of the events leading up to the Company’s restatement of its financial statements on June 25, 2002. The Department of Justice is also conducting an investigation concerning events related to the restatement.

Class Action Lawsuits

Beginning on May 15, 2002, a number of securities class actions were filed against the Company and certain of its current and former directors and former officers alleging violations of the federal securities laws. These actions were consolidated into a single action pending in the United States District Court for the Central District of California and entitled: In re Lantronix, Inc. Securities Litigation, Case No. CV 02-3899 GPS (JTLx). After the Court appointed a lead plaintiff, amended complaints were filed by the plaintiff, and the defendants filed various motions to dismiss directed at particular allegations. Through that process, certain of the allegations were dismissed by the Court.

On October 18, 2004, the plaintiff filed the third amended complaint, which is now the operative complaint in the action. The Complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933, as amended (the “Securities Act”) and violations of Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Securities Act claims are brought on behalf of all persons who purchased common stock of Lantronix pursuant or traceable to the Company’s August 4, 2000 initial public offering (“IPO”). The Exchange Act claims are based on alleged misstatements related to the Company’s financial results that were contained in the Registration Statement and Prospectus for the IPO. The claims brought under the 1934 Act are brought on behalf of all persons and entities that purchased or acquired Lantronix securities from November 1, 2000 through May 30, 2002 (the “Class Period”). The complaint alleges that defendants issued false and misleading statements concerning the business and financial condition in order to allegedly inflate the value of the Company’s securities during the Class Period. The complaint alleges that during the Class Period, Lantronix overstated financial results through improper revenue recognition and failure to comply with Generally Accepted Accounting Principles (“GAAP”). Defendants have filed an answer to the complaint and the case is now in discovery. The Court has set a trial date in September 2006. While the complaint does not specify the damages plaintiff may seek on behalf of the purported classes of stockholders, a recovery by the plaintiff and the plaintiff classes could have a material adverse impact on the Company. The proceeds from certain insurance policies have funded and continue to fund much of the Company’s defense to the class action lawsuit.

The Company is in settlement discussions in the class action and Synergetic action (described below) and has moved closer to reaching a potential settlement of both matters, which the Company has recorded as an accrued settlement and settlement recovery in the unaudited condensed consolidated balance sheets. If settlements are reached and finalized, the claims against the Company and the individual officer and director defendants would be dismissed. Under terms of the potential settlements currently being discussed, the Company will not be required to contribute any cash as all cash contributed would be from the Company’s insurance carriers, although one of the insurance carriers has to date refused to contribute sufficient funds from its policy to effect the proposed settlements. As a result of this indicated shortfall in the recovery from one of its insurance carriers, the Company has taken a charge of $2.6 million in the unaudited consolidated statement of operations because if the settlements are reached and finalized, the Company may be required at some time in the future to issue stock warrants to the plaintiffs to cover the shortfall. There is no guarantee that either of these settlements will be finalized or approved by the courts.

Derivative Lawsuit

On June 9, 2005, the Superior Court of the State of California, County of Orange, approved the settlement of a stockholder derivative action (entitled Drake v. Bruscha, et al.) pending against the Company and certain of its current and former directors and former officers. The settlement involves the adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $1.2 million. The action was dismissed with prejudice as to all parties, including Mr. Steven Cotton, who was not a party to the settlement agreement and who had objected to the settlement. As part of the settlement, the Company’s insurance carrier has agreed to pay the $1.2 million after the settlement becomes final, and the settlement will have no impact on the Company’s financial statements or results of operations. On August 12, 2005, Mr. Cotton appealed the Superior Court’s approval of the settlement, specifically challenging the amount of the $1.2 million fee award. This settlement does not impact the securities class action or Synergetic Micro Systems securities case.

Employment Suit Brought by Former Chief Financial Officer and Chief Operating Officer Steve Cotton

On September 6, 2002, Steve Cotton, the Company’s former CFO and COO, filed a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the Superior Court of the State of California, County of Orange. The complaint alleges claims for breach of contract, breach of the covenant of good faith and fair dealing, wrongful termination, misrepresentation, and defamation. The complaint seeks unspecified damages, declaratory relief, attorneys’ fees and costs.

The Company filed a motion to dismiss on October 16, 2002, on the grounds that Mr. Cotton’s complaints are subject to the binding arbitration provisions in Mr. Cotton’s employment agreement. On January 13, 2003, the Court ruled that five of the six counts in Mr. Cotton’s complaint are subject to binding arbitration. The court is staying the sixth count, for declaratory relief, until the underlying facts are resolved in arbitration. No arbitration date has been set.

Securities Claims Brought by Former Stockholders of Synergetic Micro Systems, Inc. (“Synergetic”)

On October 17, 2002, Richard Goldstein and several other former stockholders of Synergetic filed a complaint entitled Goldstein, et al. v. Lantronix, Inc., et al. in the Superior Court of the State of California, County of Orange, against the Company and certain of its former officers and directors. Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint alleges fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract and negligence, all stemming from its acquisition of Synergetic. The complaint seeks an unspecified amount of damages, interest, attorneys’ fees, costs, expenses, and an unspecified amount of punitive damages. On May 5, 2003, the Company answered the complaint and generally denied the allegations in the complaint. Discovery has commenced, and the court has scheduled a trial date set in May 2006.

The Company is in settlement discussions in the class action and Synergetic action and has moved closer to reaching a potential settlement of both matters, which the Company has recorded as an accrued settlement and settlement recovery in the unaudited condensed consolidated balance sheets. If settlements are reached and finalized, the claims against the Company and the individual officer and director defendants would be dismissed. Under terms of the potential settlements currently being discussed, the Company will not be required to contribute any cash as all cash contributed would be from the Company’s insurance carriers, although one of the insurance carriers has to date refused to contribute sufficient funds from its policy to effect the proposed settlements. As a result of this indicated shortfall in the recovery from one of its insurance carriers, the Company has taken a charge of $2.6 million in the unaudited consolidated statement of operations because if the settlements are reached and finalized, the Company may be required at some time in the future to issue stock warrants to the plaintiffs to cover the shortfall. There is no guarantee that either of these settlements will be finalized or approved by the courts.

Patent Infringement Litigation

On April 13, 2004, Digi International Inc. (“Digi”) filed a complaint against the Company in the U.S. District Court in Minnesota. The complaint alleges that certain of the Company’s products infringe Digi’s U.S. Patent No. 6,446,192. The complaint seeks both monetary and non-monetary relief. The Company has filed an answer and counterclaim alleging invalidity and non-infringement of the patent. The counterclaim seeks both monetary and non-monetary relief. The court has set a trial date in July 2006.

On May 3, 2004, the Company filed a complaint against Digi in the U.S. District Court for the Central District of California. The complaint alleges that certain of Digi’s products infringe the Company’s U.S. Patent No. 6,571,305. The Company recently amended its complaint to allege that the named Digi products also infringe the Company's U.S. Patent No. 6,922,748. The Complaint seeks both monetary and non-monetary relief. Digi has filed an answer and counterclaim alleging invalidity and non-infringement of the patent. The counterclaim seeks both monetary and non-monetary relief. Fact discovery has been completed. Trial in the case was scheduled to commence on January 17, 2006, but the trial has not yet commenced and may be rescheduled by the court.

On February 7, 2005, the Company filed a complaint against Digi in the U.S. District Court for the Eastern District of Texas. The complaint alleges that certain of Digi’s products infringe U.S. Patent No. 4,972,470, under which the Company is an exclusive licensee with respect to the field of use encompassing Digi’s accused products. The Complaint seeks both monetary and non-monetary relief. Digi has filed an answer alleging invalidity and non-infringement of the patent. The answer seeks both monetary and non-monetary relief. Discovery is ongoing in the case, and the court has set a trial date in July 2006.

On May 12, 2005, the Company filed a patent infringement complaint against Digi, in the U.S. District Court for the Eastern District of Texas. The complaint alleges that the Digi Connect ME and certain other Digi device server products infringe upon the Company’s U.S. Patent No. 6,881,096 entitled “Compact Serial-to-Ethernet Port.” Digi has filed an answer alleging invalidity and non-infringement of the patent. The answer seeks both monetary and non-monetary relief. Discovery is ongoing in the case, and the Court has set a trial date in September 2006.

Other

From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business. The Company is currently not aware of any such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its business, prospects, financial position, operating results or cash flows.

The pending lawsuits involve complex questions of fact and law and likely will continue to require the expenditure of significant funds and the diversion of other resources to defend. Management is unable to determine the outcome of its outstanding legal proceedings, claims and litigation involving the Company, its subsidiaries, directors and officers and cannot determine the extent to which these results may have a material adverse effect on the Company’s business, results of operations and financial condition taken as a whole. The results of litigation are inherently uncertain, and adverse outcomes are possible. The Company is unable to estimate the range of possible loss from outstanding litigation, and no amounts have been provided for such matters, except as disclosed above.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement

You should read the following discussion and analysis in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission (“SEC”), including our Annual Report on Form 10-K for the fiscal year ended June 30, 2005 and subsequent reports on our Current Reports on Form 8-K, which discuss our business in greater detail.

The section entitled “Risk Factors” set forth in Part II, Item 1A, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks, in addition to the other information in this Quarterly Report on Form 10-Q and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

This report contains forward-looking statements which include, but are not limited to, statements concerning projected net revenues, expenses, gross profit and income (loss), the need for additional capital, market acceptance of our products, our ability to achieve further product integration, the status of evolving technologies and their growth potential and our production capacity. Among these forward-looking statements are statements regarding a potential decline in net revenue from non-core product lines, potential variances in quarterly operating expenses, the adequacy of existing resources to meet cash needs and the potential impact of an increase in interest rates on our financial condition or results of operations. These forward-looking statements are based on our current expectations, estimates and projections about our industry, our beliefs and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, including but not limited to those identified under the heading “Risk Factors” set forth in Part II, Item 1A. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Overview

Lantronix, Inc. (“Lantronix” or “the Company”) designs, develops and markets devices that make it possible to access, manage, control and configure electronic products over the Internet or other networks. We are a leader in providing innovative networking solutions. We were initially formed as “Lantronix,” a California corporation, in June 1989. We reincorporated as “Lantronix, Inc.,” a Delaware corporation, in May 2000.

We have a history of providing devices that enable information technology (“IT”) equipment to network using standard protocols for connectivity, including Ethernet and wireless. Our first device was a terminal server that allowed “dumb” terminals to connect to a network. Building on the success of our terminal servers, in 1991 we introduced a complete line of print servers that enabled users to inexpensively share printers over a network. Since then, we have continually refined our core technology and have developed additional innovative networking solutions that expand upon the business of providing our customers network connectivity. With the expansion of networking and the Internet, our technology focus has been increasingly broader and has expanded beyond IT equipment, so that our device solutions provide a product manufacturer with the ability to network its products within the industrial, service and commercial markets.

We provide three broad categories of products: “device networking solutions” that enable electronic products to be connected to a network; “IT management solutions” that enable multiple pieces of equipment, usually IT-related network hardware such as servers, routers, switches and similar pieces of equipment to be managed over a network; and “non-core” products and services that include visualization solutions, legacy print servers and other miscellaneous products. The expansion of our business in the future is directed at the first two of these categories, which comprise our “core” businesses of device networking and IT management solutions.

Today, our solutions include fully integrated hardware and software devices, as well as software tools, to develop related customer applications. Because we deal with network connectivity, we provide solutions to extremely broad market segments, including industrial, retail, medical, commercial, financial, governmental, building automation and many more. Our technology is used to provide networking capabilities to products such as medical equipment, manufacturing equipment, bar code scanners, building heating ventilation and air conditioning systems, elevators, process control equipment, vending machines, thermostats, security cameras, temperature sensors, card readers, point of sale terminals, time clocks and virtually any product that has some form of standard data control capability.

We sell our products through a global network of distributors, systems integrators, value-added resellers (“VARs”), manufacturers’ representatives and original equipment manufacturers (“OEMs”). In addition, we sell directly to selected accounts.

Financial Highlights and Other Information for the Fiscal Quarter Ended December 31, 2005

The following is a summary of the key factors and significant events which impacted our financial performance during the fiscal quarter ended December 31, 2005:

Net revenues of $13.0 million for the fiscal quarter ended December 31, 2005 increased by $47,000 or 0.4% as compared to $12.9 million reported during the fiscal quarter ended December 31, 2004. The revenue increase is primarily due to an increase in our device networking product line of $896,000 or 11.1%, which was offset by decreases in our IT management and non-core product lines of $451,000 and $398,000, respectively. Net revenues of $13.0 million for the fiscal quarter ended December 31, 2005 increased by $715,000 or 5.8% as compared to $12.2 million reported during the fiscal quarter ended September 30, 2005. The revenue increase is primarily due to increases in our device networking product line of $718,000 or 8.7% and IT management product line of $65,000 or 2.3%, which was offset by a decrease in our non-core product line of $68,000.

Gross profit as a percentage of net revenues was 50.9% for the fiscal quarter ended December 31, 2005, increasing 2.4 percentage points from the 48.5% reported in the fiscal quarter ended December 31, 2004. The increase in gross profit is primarily due to a decrease in the amortization of purchased intangible assets, a reduction in product warranty reserves to reflect a decrease in our product return rates and a reduction in manufacturing overhead costs, which was offset by an increase in volumes of lower margin products.

Loss from operations as a percentage of net revenues was 27.3% for the fiscal quarter ended December 31, 2005 compared to 14.7% in the fiscal quarter ended December 31, 2004. The decrease is primarily due to a $2.6 million accrual for litigation settlement costs and a $139,000 increase in share-based compensation expense recorded in connection with our July 1, 2005 adoption of a new accounting standard as further described below, offset by a $1.2 million decrease in operating expenses.

Net loss of $3.6 million or $0.06 per diluted share, in the fiscal quarter ended December 31, 2005, increased from a net loss of $1.5 million, or $0.03 per diluted share, in the fiscal quarter ended December 31, 2004.

Cash, cash equivalents and marketable securities increased from $6.8 million as of June 30, 2005, to $6.9 million as of September 30, 2005 to $7.3 million as of December 31, 2005.

Accounts receivable were $2.5 million as of December 31, 2005 as compared to $2.6 million at June 30, 2005. Days sales outstanding (“DSO”) in receivables as of December 31, 2005 improved to 18.4 days from 22.2 days as of June 30, 2005. Our accounts receivable and DSO are primarily affected by the linearity of shipments within the year, our collections performance and the fact that a significant portion of our revenues are recognized on a sell-through basis (upon shipment from distributor inventories rather than as goods are shipped to distributors).

Inventories were $6.6 million as of December 31, 2005 as compared to $6.8 million as of June 30, 2005. Our annualized inventory turns of 3.8 as of December 31, 2005 improved from the 3.6 turns as of June 30, 2005.

Critical Accounting Policies and Estimates

The accounting policies that have the greatest impact on our financial condition and results of operations and that require the most judgment are those relating to revenue recognition, allowance for doubtful accounts, inventory valuation, valuation of deferred income taxes, goodwill and purchased intangible assets and legal settlement costs. These policies are described in further detail in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005.

Adoption of SFAS 123R

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”). This Statement requires companies to expense the estimated fair value of stock options and similar equity instruments issued to employees over the requisite service period. SFAS 123R eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees if certain conditions were met. However, under APB 25 and related accounting guidance, we recognized compensation expense for in-the-money option grants to employees and employee stock options assumed by us in connection with our acquisitions of the businesses that previously employed those individuals. Additionally, the pro forma impact from recognition of the estimated fair value of stock options granted to employees has been disclosed in our footnotes as required under previous accounting rules.

The fair value concepts were not changed significantly in SFAS 123R; however, in adopting this SFAS 123R, companies must choose among alternative valuation models and amortization assumptions. After assessing alternative valuation models and amortization assumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”) option-pricing formula and straight-line amortization of compensation expense over the requisite service period of the grant. We will reconsider use of this model if additional information becomes available in the future that indicates another model would be more appropriate for us, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), we were not required to estimate forfeitures in our expense calculation for the stock compensation pro forma footnote disclosure; however, SFAS 123R requires an estimate of forfeitures and upon adoption we changed our methodology to include an estimate of forfeitures.

The following table illustrates (i) the impact of adopting SFAS 123R on loss before income taxes, net loss and basic and diluted loss per share and (ii) as if we had continued to account for share-based compensation under APB 25 (in thousands, except per share data):

	Three Months Ended						Six Months Ended
	December 31, 2005						December 31, 2005
	SFAS 123R			APB 25			SFAS 123R			APB 25
Loss before income taxes	$	(3,561	)	$	(3,332	)	$	(4,896	)	$	(4,433	)
Net loss	$	(3,571	)	$	(3,342	)	$	(4,912	)	$	(4,449	)
Basic and diluted net loss per share	$	(0.06	)	$	(0.06	)	$	(0.08	)	$	(0.08	)

The following table illustrates the effect on net loss and loss per share if we had applied the fair value recognition provisions of SFAS 123 to options granted under our stock option plans in the first fiscal quarter of 2005. For purposes of this pro forma disclosure, the fair value of the options is estimated using a BSM option-pricing formula and amortized on a straight-line basis to expense over the options’ vesting period (in thousands, except per share data):

	Three Months Ended			Six Months Ended
	December 31,			December 31,
	2004			2004

Net loss - as reported	$	(1,538	)	$	(5,093	)
Add: Share-based employee compensation expense included
in net loss, net of related tax effects - as reported		96			158
Deduct: Share-based employee compensation expense determined
under fair value method, net of related tax effects - pro forma		(370	)		(816	)
Net loss - pro forma	$	(1,812	)	$	(5,751	)
Basic and diluted net loss per share - as reported	$	(0.03	)	$	(0.09	)
Basic and diluted net loss per share - pro forma	$	(0.03	)	$	(0.10	)

Total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized is as follows (in thousands):

	December 31, 2005
Cost of revenues	$	139
Sales, general and administrative		967
Research and development		314
Total	$	1,420

Weighted-average remaining years		2.5

Recent Accounting Pronouncements

Recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants and the SEC did not or are not believed by management to have a material impact on our present or future consolidated financial statements.

Consolidated Results of Operations

The following table sets forth, for the periods indicated, the percentage of net revenues represented by each item in our condensed consolidated statement of operations:

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2005		2004		2005		2004

Net revenues		100.0%		100.0%		100.0%		100.0%
Cost of revenues		48.9%		51.5%		49.3%		50.7%
Cost of revenues - share-based compensation		0.2%		0.0%		0.2%		0.0%
Gross profit		50.9%		48.5%		50.5%		49.3%
Operating expenses:
Selling, general and administrative		46.8%		51.3%		47.5%		56.0%
Selling, general and administrative - share-based compensation		1.2%		0.7%		1.3%		0.6%
Research and development		9.7%		11.0%		10.4%		15.5%
Research and development - share-based compensation		0.4%		0.0%		0.4%		0.0%
Amortization of purchased intangible assets		0.0%		0.1%		0.0%		0.2%
Restructuring recovery		0.0%		0.0%		(0.1%)		0.0%
Litigation settlement costs		20.1%		0.0%		10.3%		0.0%
Total operating expenses		78.2%		63.2%		69.8%		72.4%
Loss from operations		(27.3%)		(14.7%)		(19.3%)		(23.1%)
Interest income, net		0.1%		0.1%		0.1%		0.1%
Other income (expense), net		(0.3%)		3.5%		(0.2%)		2.2%
Loss before income taxes		(27.5%)		(11.1%)		(19.4%)		(20.8%)
Provision for income taxes		0.1%		0.8%		0.1%		0.7%
Loss from continuing operations		(27.6%)		(11.9%)		(19.5%)		(21.5%)
Income from discontinued operations		0.0%		0.0%		0.0%		0.2%
Net loss		(27.6%)		(11.9%)		(19.5%)		(21.3%)

Comparison of the Three and Six Months Ended December 31, 2005 and 2004

Net Revenues by Product Category (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Device networking	$	8,975		69.3%	$	8,079		62.6%	$	896			11.1%
IT management		2,848		22.0%		3,299		25.6%		(451	)		(13.7%)
Non-core		1,132		8.7%		1,530		11.8%		(398	)		(26.0%)
Total	$	12,955		100.0%	$	12,908		100.0%	$	47			0.4%

	Six Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Device networking	$	17,232		68.4%	$	14,305		59.7%	$	2,927			20.5%
IT management		5,631		22.3%		6,421		26.8%		(790	)		(12.3%)
Non-core		2,332		9.3%		3,227		13.5%		(895	)		(27.7%)
Total	$	25,195		100.0%	$	23,953		100.0%	$	1,242			5.2%

The increase in net revenues for the three months ended December 31, 2005 as compared to the same period one year ago was a result of an increase in net revenues from our device networking products, offset by a decrease in demand in our IT management products, and to a lesser extent, our non-core products. The increase in our device networking product line is primarily due to an increase in volume in our X-port products. The decrease in our non-core product net revenues is primarily due to a decrease in demand of our visualization and print server products. We are no longer investing in the development of our non-core product lines and expect net revenues related to these products to continue to decline in the future as we focus our investment in device networking and certain IT management products.

The increase in net revenues for the six months ended December 31, 2005 as compared to the same period one year ago was a result of an increase in net revenues from our device networking products, offset by a decrease in demand in our IT management products, and our non-core products. The increase in our device networking product line is primarily due to an increase in volume in our X-port products. The decrease in our non-core product net revenues is primarily due to a decrease in demand of our visualization, Stallion and print server products. We are no longer investing in the development of our non-core product lines and expect net revenues related to these products to continue to decline in the future as we focus our investment in device networking and certain IT management products.

Net Revenues by Region (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Americas	$	7,893		60.9%	$	8,463		65.6%	$	(570	)		(6.7%)
EMEA		3,609		27.9%		3,412		26.4%		197			5.8%
Asia Pacific		1,453		11.2%		1,033		8.0%		420			40.7%
Total	$	12,955		100.0%	$	12,908		100.0%	$	47			0.4%

	Six Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Americas	$	16,072		63.8%	$	15,994		66.8%	$	78		0.5%
EMEA		6,568		26.1%		6,205		25.9%		363		5.9%
Asia Pacific		2,555		10.1%		1,754		7.3%		801		45.7%
Total	$	25,195		100.0%	$	23,953		100.0%	$	1,242		5.2%

The increase for the three months ended December 31, 2005 as compared to the same period one year ago is a result of an increase in net revenues in the EMEA (“Europe, Middle East and Africa”) and Asia Pacific regions offset by a decrease in the Americas region. The decrease in net revenues in the Americas region is primarily attributable to lower sales of IT management and non-core products offset by higher sales of device networking products. The increase in the EMEA and Asia Pacific regions is primarily due to growth in our device networking business.

The increase for the six months ended December 31, 2005 as compared to the same period one year ago is a result of an increase in net revenues in all regions. The increase in net revenues in the Americas region is primarily attributable to higher sales of device networking products offset by lower sales of IT management and non-core products. The increase in the EMEA and Asia Pacific regions is primarily due to growth in our device networking business.

Gross Profit (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Gross profit	$	6,598		50.9%	$	6,256		48.5%	$	342		5.5%

	Six Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Gross profit	$	12,718		50.5%	$	11,813		49.3%	$	905		7.7%

Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of raw material components, subcontract labor assembly from outside manufacturers, amortization of purchased intangible assets, establishing or relieving inventory reserves for excess and obsolete products or raw materials, overhead, royalty, warranty costs and share-based compensation. The increase in gross profit is primarily due to a decrease in the amortization of purchased intangible assets, a reduction in product warranty reserves to reflect a decrease in our product return rates and a reduction in manufacturing overhead and royalty costs, which was offset by an increase in volumes of lower margin products.

Cost of revenues includes amortization of purchased intangible assets as follows (in thousands):

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2005		2004		2005		2004
Amortization of purchased intangible assets	$	223	$	364	$	520	$	729

The unamortized balance of purchased intangible assets will be amortized to cost of revenues as follows (in thousands):

	2006		2007		Total

Amount remaining to be amortized	$	143	$	103	$	246

Selling, General and Administrative (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Selling, general and administrative (1)	$	6,057		46.8%	$	6,628		51.3%	$	(571	)		(8.6%)
Selling, general and administrative
- share-based compensation	$	161		1.2%	$	96		0.7%	$	65			67.7%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.

	Six Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Selling, general and administrative (1)	$	11,962		47.5%	$	13,428		56.1%	$	(1,466	)		(10.9%)
Selling, general and administrative
- share-based compensation	$	328		1.3%	$	153		0.6%	$	175			114.4%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.

Selling, general and administrative expenses consist primarily of personnel-related expenses including salaries and commissions, facility expenses, information technology, trade show expenses, advertising, insurance proceeds, purchased patents and professional legal and accounting fees.

The decrease in selling, general and administrative expense for the three and six months ended December 31, 2005 is primarily due to a reduction in headcount, depreciation expense, and selling expenses, partially offset by an increase in professional fees.

The increase in share-based compensation expense is due to our adoption of SFAS 123R as of July 1, 2005. See above section, Adoption of SFAS 123R, for additional detail.

Research and Development (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Research and development (1)	$	1,257		9.7%	$	1,421		11.0%	$	(164	)		(11.5%)
Research and development
- share-based compensation	$	53		0.4%	$	-		0.0%	$	53			N/A
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.

	Six Months Ended
	December 31,
			% of Net				% of Net		$			%
	2005		Revenue		2004		Revenue		Variance			Variance

Research and development (1)	$	2,608		10.4%	$	3,716		15.5%	$	(1,108	)		(29.8%)
Research and development
- share-based compensation	$	105		0.4%	$	5		0.0%	$	100			2000.0%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.

Research and development expenses consist primarily of personnel-related costs of employees, as well as expenditures to third-party vendors for research and development activities.

The decrease in research and development expenses for the three and six months ended December 31, 2005 is primarily due to a reduction in headcount.

The increase in share-based compensation expense is due to our adoption of SFAS 123R as of July 1, 2005. See above section, Adoption of SFAS 123R, for additional detail.

Restructuring Charges

During the six months ended December 31, 2005, approximately $29,000 of restructuring charges were recovered as a result of a decrease in our expected liability related to the consolidation of excess facilities that occurred during our fiscal 2004 and 2003 restructurings.

Litigation Settlement Costs (in thousands)

	Three Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Litigation settlement costs	$	2,600		20.1%	$	-		0.0%	$	2,600		N/A

	Six Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Litigation settlement costs	$	2,600		10.3%	$	-		0.0%	$	2,600		N/A

Increase for the three and six months ended December 31, 2005 is due to litigation settlement costs. Refer to Note 11 to our notes to the unaudited condensed consolidated financial statements for further discussion.

Other Income (Expense), Net (in thousands)

	Three Months Ended
	December 31,
				% of Net				% of Net		$			%
	2005			Revenue		2004		Revenue		Variance			Variance

Other income (expense), net	$	(49	)		(0.4%)	$	472		3.7%	$	(521	)		N/A

	Six Months Ended
	December 31,
				% of Net				% of Net		$			%
	2005			Revenue		2004		Revenue		Variance			Variance

Other income (expense), net	$	(59	)		(0.2%)	$	542		2.3%	$	(601	)		N/A

The increase in other expense for the three and six months ended December 31, 2005 is primarily due to foreign exchange losses.

Provision for Income Taxes - Effective Tax Rate

The Company utilizes the liability method of accounting for income taxes. The following table shows the Company’s effective tax rates for the periods shown:

	Three Months Ended		Six Months Ended
	December 31,		December 31,
	2005	2004	2005	2004

Effective tax rate	0%	8%	0%	3%

Liquidity and Capital Resources

Since inception, we have financed our operations through the issuance of common stock and through net cash generated from operations. We consider all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents.

The following table summarizes the major components of the consolidated statement of cash flows (in thousands):

	Six Months Ended
	December 31,
	2005			2004
Net cash provided by (used in):
Net loss	$	(4,912	)	$	(5,093	)
Non-cash operating expenses, net		3,716			1,017
Changes in operating assets and liabilities		1,824			478
Net cash provided by (used in) operating activities		628			(3,598	)
Net cash (used in) provided by investing activities		(132	)		2,346
Net cash provided by (used in) financing activities		121			(811	)
Effect of foreign exchange rate changes on cash		(113	)		541
Increase (decrease) in cash and cash equivalents	$	504		$	(1,522	)

		December 31,			June 30,
		2005			2005
Cash and cash equivalents	$	7,194		$	6,690
Marketable securities		97			85
	$	7,291		$	6,775

Our cash, cash equivalents and marketable securities balances increased by approximately $170,000, from $6.8 million at June 30, 2005, to $6.9 million at September 30, 2005. During the second quarter ended December 31, 2005 our cash and cash equivalents and marketable securities increased by an additional $346,000 to $7.3 million. We refer to the sum of these components as “cash” for the purpose of discussing our cash usage and liquidity.

Operating activities provided cash for the six months ended December 31, 2005. This was primarily the result of the net loss offset by net cash provided from changes in operating assets and liabilities and non-cash operating expenses. Non-cash items that had a significant impact on net loss included litigation settlement costs, depreciation, amortization of purchased intangible assets and share-based compensation. Changes in operating assets and liabilities which had a significant impact on the cash provided by operating activities included accounts payable and other liabilities.

Operating activities used cash for the six months ended December 31, 2004. This was primarily the result of the net loss offset by net cash provided from changes in operating assets and liabilities and non-cash operating expenses. Non-cash items that had a significant impact on net loss included depreciation, amortization of purchased intangible assets, share-based compensation, provision for doubtful accounts and foreign currency transaction gain.

Investing activities used cash for the six months ended December 31, 2005. This was for the purchase of property and equipment. Investing activities provided $2.3 million in cash for the six months ended December 31, 2004. This was primarily due to net proceeds from the purchase and sale of marketable securities.

Financing activities provided cash for the six months ended December 31, 2005. We received $200,000 related to the purchase of common shares through option exercises and the Employee Stock Purchase Plan offset by $79,000 used to repay capital lease obligations. Financing activities used $811,000 in cash in the six months ended December 31, 2004. This was primarily due to a $867,000 payment to retire our convertible note payable and $250,000 in payments on our line of credit offset by $306,000 in proceeds from the purchase of common shares through option exercises and the Employee Stock Purchase Plan.

Our revolving credit line at June 30, 2005 was $3.0 million. As of June 30, 2005, we had no borrowings against this line of credit. Additionally, we have used letters of credit available under the line of credit totaling approximately $480,000 in place of cash to fund deposits on leases, tax account deposits and security deposits. As a result, our available line of credit at June 30, 2005 was $2.5 million. Pursuant to the line of credit, we were restricted from paying any dividends. As of June 30, 2005, we were not in compliance with the quick ratio covenant as defined in the agreement. A waiver was granted by the bank during August 2005. The line of credit expired July 22, 2005. We are in the process of obtaining a new line of credit.

As of December 31, 2005, approximately $2.2 million of our tangible assets (primarily cash held in foreign subsidiary bank accounts) were held by subsidiaries outside the U.S. Such assets are unrestricted with regard to foreign liquidity needs, however, our ability to utilize a portion of such assets to satisfy liquidity needs outside of such foreign locations are subject to approval by the foreign locations’ board of directors.

The cumulative effect of the reductions initiated in October 2004 through January 2005 is that we have lowered our operating costs to streamline operations and lower our cash breakeven point from the earlier revenue range of $14-15 million in quarterly revenues as an operating model, to approximately $13 million per quarter. This target is based upon a financial model, and we expect that actual expenses may vary in any quarter and therefore financial results impacting cash usage or profitability will vary. Also, uses of cash to fund inventories, receivables and payables will cause results to vary from the financial model.

We believe that our existing cash, cash equivalents and marketable securities will be adequate to meet our anticipated cash needs through at least the next twelve months. Our future capital requirements will depend on many factors, including the timing and amount of our net revenues, research and development and infrastructure investments, and expenses related to ongoing government investigations and pending litigation, which will affect our ability to generate additional cash. If cash generated from operations and financing activities is insufficient to satisfy our working capital requirements, we may need to borrow funds through bank loans, sales of securities or other means. We are in the process of negotiating a new bank line of credit. There can be no assurance that we will be able to raise any such capital on terms acceptable to us, if at all. If we are unable to secure additional financing, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competition or continue to operate our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Our exposure to interest rate risk is limited to the exposure related to our cash and cash equivalents, which is tied to market interest rates. We had the following cash and cash equivalents and marketable securities consisting of publicly traded equity securities (in thousands) for the periods indicated:

	December 31,		June 30,
	2005		2005
Cash and cash equivalents	$	7,194	$	6,690
Marketable securities		97		85
Total	$	7,291	$	6,775

We believe our cash and cash equivalents and marketable securities would not decline in value by a significant amount if interest rates increase, and therefore would not have a material effect on our financial condition or results of operations.

Foreign Currency Risk

We sell products internationally. As a result, our financial results could be harmed by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act as of the end of our fiscal quarter ended December 31, 2005. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in internal controls over financial reporting

As described in our Form 10-K filed on September 28, 2005, in connection with our fiscal 2005 financial statement close, we determined and concluded that there were significant deficiencies in our financial statement close process. We concluded that those conditions constituted a material weakness in our internal controls over financial reporting. During our fiscal quarter ended September 30, 2005, we implemented certain improvements to our internal control over financial reporting, as described in more detail in our Form 10-Q filed with the SEC on November 14, 2005. There has not been any change in our internal control over financial reporting that occurred during our fiscal quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

In January 2006, management initiated, with the Audit Committee’s concurrence, we initiated a process whereby all incoming invoices are recorded by our accounts payable function upon receipt.

In addition we anticipate identifying a qualified external GAAP expert to review our accounting conclusions on complex transactions we may enter into from time to time.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth in Note 11 to our notes to the unaudited condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q is hereby incorporated by reference.

Item 1A. Risk Factors

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below, in addition to the other cautionary statements and risks described elsewhere and the other information contained in this Quarterly Report on Form 10-Q and in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on Lantronix, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

Our quarterly operating results may fluctuate, which could cause our stock to decline.

We have experienced, and expect to continue to experience, significant fluctuations in revenues, expenses and operating results from quarter to quarter. We, therefore, believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance, and you should not rely on them to predict our future performance or the future performance of our stock. Our short-term expense levels for ongoing operations are relatively fixed and are based on our expectations of future net revenues. If we were to experience a reduction in revenues in a quarter, we would likely be unable to adjust our short-term expenditures. If this were to occur, our operating results for that fiscal quarter would be harmed. If our operating results in future fiscal quarters fall below the expectations of market analysts and investors, the price of our common stock would likely fall. Other factors that might cause our operating results to fluctuate on a quarterly basis include:

changes in the mix of net revenues attributable to higher-margin and lower-margin products;

customers’ decisions to defer or accelerate orders;

variations in the size or timing of orders for our products;

changes in demand for our products;

defects and other product quality problems;

loss or gain of significant customers;

short-term fluctuations in the cost or availability of our critical components;

announcements or introductions of new products by our competitors;

effects of terrorist attacks in the U.S. and abroad; and

changes in demand for devices that incorporate our products.

Current or future litigation could adversely affect us.

We are currently involved in significant litigation, including multiple security class action lawsuits, a state derivative lawsuit, significant patent infringement litigation, and litigation with a former executive officer. The pending lawsuits involve complex questions of fact and law and will likely continue to require the expenditure of significant funds and the diversion of other resources. We do not know what the outcome of outstanding legal proceedings will be and cannot determine the extent to which these resolutions might have a material adverse effect on our business, financial condition or results of operations. The results of litigation are inherently uncertain, and adverse outcomes are possible. For a more detailed description of pending litigation, see Note 11 to our notes to the unaudited condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q.

From time to time, we are subject to other legal proceedings and claims. Litigation can involve complex factual and legal questions and its outcome is uncertain. Any claim that is successfully asserted against us may cause us to pay substantial damages. Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could have a material adverse effect on us.

Current or future litigation over intellectual property rights could adversely affect us.

Substantial litigation regarding intellectual property rights exists in our industry. For example, Digi International (“Digi”) has filed a lawsuit against us alleging that we infringe one of their patents, and we have filed three suits against Digi alleging that they infringe patents that we own or license. These pending lawsuits involve complex questions of fact and law and will likely continue to require the expenditure of significant funds and the diversion of other resources. We do not know what the outcome of these legal proceedings will be and cannot determine the extent to which resolutions of these disputes might have a material adverse effect on our business, financial condition or results of operations. The results of litigation are inherently uncertain, and adverse outcomes are possible. For a more detailed description of pending litigation, see Note 11 to the notes to our unaudited condensed consolidated financial statements of Part I, Item I of this Form 10-Q.

There is a risk that other third parties will claim that our products, or our customers’ products, infringe on their intellectual property rights or that we have misappropriated their intellectual property. In addition, software, business processes and other property rights in our industry might be increasingly subject to third-party infringement claims as the number of competitors grows and the functionality of products in different industry segments overlaps. Other parties might currently have, or might eventually be issued, patents that pertain to the proprietary rights we use. Any of these third parties might make a claim of infringement against us. The results of litigation are inherently uncertain, and adverse outcomes are possible.

Responding to any infringement claim, regardless of its validity, could:

be time-consuming, costly and/or result in litigation;

divert management’s time and attention from developing our business;

require us to pay monetary damages, including treble damages if we are held to have willfully infringed;

require us to enter into royalty and licensing agreements that we would not normally find acceptable;

require us to stop selling or to redesign certain of our products; or

require us to satisfy indemnification obligations to our customers.

If any of these occur, our business, financial condition or results of operations could be adversely affected.

Our use of contract manufacturers in China and Taiwan involves risks that could adversely affect us.

We use contract manufacturers based in China and Taiwan. There are significant risks of doing business in these locations, including the following:

These locations do not afford the same level of protection to intellectual property as do domestic or many foreign countries. If our products were reverse-engineered or our intellectual property were otherwise pirated (reproduced and duplicated without our knowledge or approval), our revenues would be reduced;

Delivery times are extended due to the distances involved, requiring more lead-time in ordering and increasing the risk of excess inventories;

We could incur ocean freight delays because of labor problems, weather delays or customs problems; and

U.S. foreign relations with these locations have, historically, been subject to change. Political considerations and actions could interrupt our expected supply of products from these locations.

Delays in deliveries or quality problems with our component suppliers could damage our reputation and could cause our net revenues to decline and harm our results of operations.

We and our contract manufacturers are responsible for procuring raw materials for our products. Our products incorporate components or technologies that are only available from single or limited sources of supply. In particular, some of our integrated circuits are only available from a single source and in some cases are no longer being manufactured. From time to time, integrated circuits used in our products will be phased out of production. When this happens, we attempt to purchase sufficient inventory to meet our needs until a substitute component can be incorporated into our products. Nonetheless, we might be unable to purchase sufficient components to meet our demands, or we might incorrectly forecast our demands, and purchase too many or too few components. In addition, our products use components that have, in the past, been subject to market shortages and substantial price fluctuations. From time to time, we have been unable to meet our orders because we were unable to purchase necessary components for our products. We do not have long-term supply arrangements with many of our vendors to obtain necessary components or technology for our products. If we are unable to purchase components from these suppliers, product shipments could be prevented or delayed, which could result in a loss of sales. If we are unable to meet existing orders or to enter into new orders because of a shortage in components, we will likely lose net revenues and risk losing customers and harming our reputation in the marketplace, which could adversely effect our business, financial condition or results of operations.

If we lose the services of any of our contract manufacturers or suppliers, we may not be able to obtain alternate sources in a timely manner, which could harm our customer relations and adversely affect our net revenues and harm our results of operations.

We do not have long-term agreements with our contract manufacturers or suppliers. If any of these subcontractors or suppliers ceased doing business with us, we may not be able to obtain alternative sources in a timely or cost-effective manner. Due to the amount of time that it usually takes us to qualify contract manufacturers and suppliers, we could experience delays in product shipments if we are required to find alternative subcontractors and suppliers. Some of our suppliers have or provide technology or trade secrets, the loss of which could be disruptive to our procurement and supply processes. If a competitor should acquire one of our contract manufacturers or suppliers, we could be subjected to more difficulties in maintaining or developing alternative sources of supply of some components or products. Any problems that we may encounter with the delivery, quality or cost of our products could damage our customer relationships and materially and adversely affect our business, financial condition or results of operations.

If our research and development efforts are not successful, our net revenues could decline and our business could be harmed.

If we are unable to develop new products as a result of our research and development efforts, or if the products we develop are not successful, our business could be harmed. Even if we do develop new products that are accepted by our target markets, we do not know whether the net revenue from these products will be sufficient to justify our investment in research and development. In addition, if we do not invest sufficiently in research and development, we may be unable to maintain our competitive position. Our research and development expenses has decreased, which may put us at a competitive disadvantage compared to our competitors and adversely affect our market position. The following table shows our research and development expenditures and percentages of net revenue for the periods indicated (amounts in thousands, except percentages):

	Six Months Ended
	December 31,
	2005		2004
Research and development (1)	$	2,608	$	3,716
Research and development - share-based compensation		105		5
	$	2,713	$	3,721
Research and development as a percent of net revenue		10.8%		15.5%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.

If a major customer cancels, reduces or delays purchases, our net revenues might decline and our business could be adversely affected.

The number and timing of sales to our distributors have been difficult for us to predict. While our distributors are customers in the sense they buy our products, they are also part of our product distribution system. To some extent, any business lost from a distributor would likely be replaced by sales to other customer/distributors in a reasonable period, rather than a total loss of that business such as from a customer who used our products in their business. Some of our distributors could be acquired by a competitor and stop buying product from us. The following table presents our largest customers as a percentage of net revenue for the periods indicated:

	Six Months Ended
	December 31,
	2005		2004
Top five customers		43.0%		44.4%
Ingram Micro		13.0%		18.1%
Tech Data		13.0%		10.8%

Below is a table of our two largest customers as a percentage of accounts receivable, net for the periods indicated:

	Six Months Ended
	December 31,
	2005		2004
Ingram Micro		22.1%		19.0%
Tech Data		*		12.9%

* Less than 10% of accounts receivable, net.

The loss or deferral of one or more significant sales in a quarter could harm our operating results. We have in the past, and might in the future, lose one or more major customers. If we fail to continue to sell to our major customers in the quantities we anticipate, or if any of these customers terminate our relationship, our reputation, the perception of our products and technology in the marketplace, could be harmed. The demand for our products from our OEM, VAR and systems integrator customers depends primarily on their ability to successfully sell their products that incorporate our device networking solutions technology. Our sales are usually completed on a purchase order basis and we have few long-term purchase commitments from our customers.

Our future success also depends on our ability to attract new customers, which often involves an extended selling process. The sale of our products often involves a significant technical evaluation, and we often face delays because of our customers’ internal procedures for evaluating and deploying new technologies. For these and other reasons, the sales cycle associated with our products is typically lengthy, often lasting six to nine months and sometimes longer. Therefore, if we were to lose a major customer, we might not be able to replace the customer in a timely manner, or at all. This would cause our net revenues to decrease and could cause our stock price to decline.

If we fail to develop or enhance our products to respond to changing market conditions and government and industry standards, our competitive position will suffer and our business will be adversely affected.

Our future success depends in large part on our ability to continue to enhance existing products, lower product cost and develop new products that maintain technological competitiveness and meet government and industry standards. The demand for network-enabled products is relatively new and can change as a result of innovations, changes or new government and industry standards. For example, industry segments might adopt new or different standards, giving rise to new customer requirements. On January 27, 2003, the European Parliament and the Council of the European Union authorized Directive 2002/95/EC on the restriction of the use of certain hazardous substances in electrical and electronic equipment. This new directive, also referred to as RoHS, requires that manufacturers reduce usage of six hazardous substances to minimum acceptable levels by July of 2006. Any failure by us to develop and introduce new products or enhancements in response to new government and industry standards could harm our business, financial condition or results of operations. These requirements might or might not be compatible with our current or future product offerings. We might not be successful in modifying our products and services to address these requirements and standards. For example, our competitors might develop competing technologies based on Internet Protocols, Ethernet Protocols or other protocols that might have advantages over our products. If this were to happen, our net revenue might not grow at the rate we anticipate, or could decline.

We expect the average selling prices of our products to decline, which could reduce our net revenues, gross margins and profitability.

In the past, we have experienced some reduction in the average selling prices and gross margins of products, and we expect that this will continue for our products as they mature. We expect competition to continue to increase, and we anticipate this could result in additional downward pressure on our pricing. Our average selling prices for our products might decline as a result of other reasons, including promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. We also may not be able to increase the price of our products if the prices of components or our overhead costs increase. In addition, we may be unable to adjust our prices in response to currency exchange rate fluctuations resulting in lower gross margins. If these were to occur, our gross margins would decline and we may not be able to reduce the cost to manufacture our products to keep up with the decline in prices.

If the SEC should levy fines against us, or to have violated the rules regarding offering securities to the public, it could damage our reputation with customers and vendors and adversely affect our stock price.

The SEC is investigating the events surrounding the restatement of our financial statements filed on June 25, 2002 for the fiscal year ended June 30, 2001 and for the six months ended December 31, 2002. The SEC could conclude that we violated the rules of the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In either event, the SEC might levy civil fines against us, or might conclude that we lack sufficient internal controls to warrant our being allowed to continue offering our shares to the public. This investigation involves substantial cost. These costs, and the cost of any fines imposed by the SEC, are not covered by insurance. In addition to sanctions imposed by the SEC, an adverse determination could significantly damage our reputation with customers and vendors, and harm our employees’ morale.

If software that we license or acquire from the open source software community and incorporate into our products were to become unavailable or no longer available on commercially reasonable terms, it could adversely affect sales of our products, which could disrupt our business and harm our financial results.

Certain of our products contain components developed and maintained by third-party software vendors or are available through the “open source” software community. We also expect that we may incorporate software from third-party vendors and open source software in our future products. Our business would be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case, we would be required to either redesign our products to function with alternate third-party software or open source software, or develop these components ourselves, which would result in increased costs and could result in delays in our product shipments. Furthermore, we might be forced to limit the features available in our current or future product offerings. We are presently developing products for use on the Linux platform. The SCO Group (“SCO”) has filed and threatened to file lawsuits against companies that operate Linux for commercial purposes, alleging that such use of Linux infringes SCO’s rights. These allegations may adversely affect the demand for the Linux platform and, consequently, the sales of our Linux-based products.

Our products may contain undetected software or hardware errors or defects that could lead to an increase in our costs, reduce our net revenues or damage our reputation.

We currently offer warranties ranging from one to two years on each of our products. Our products could contain undetected errors or defects. If there is a product failure, we might have to replace all affected products without being able to book revenue for replacement units, or we may have to refund the purchase price for the units. We do not have a long history with which to assess the risks of unexpected product failures or defects for our device server product line. Regardless of the amount of testing we undertake, some errors might be discovered only after a product has been installed and used by customers. Any errors discovered after commercial release could result in loss of net revenues and claims against us. Significant product warranty claims against us could harm our business, reputation and financial results and cause the price of our stock to decline.

If our contract manufacturers are unable or unwilling to manufacture our products at the quality and quantity we request, our business could be harmed.

We outsource substantially all of our manufacturing to three manufacturers: Venture Electronics Services, Uni Precision Industrial Ltd., and Universal Scientific Industrial Company, LTD. Our reliance on these third-party manufacturers exposes us to a number of significant risks, including:

reduced control over delivery schedules, quality assurance, manufacturing yields and production costs;

lack of guaranteed production capacity or product supply; and

reliance on these manufacturers to maintain competitive manufacturing technologies.

Our agreements with these manufacturers provide for services on a purchase order basis. If our manufacturers were to become unable or unwilling to continue to manufacture our products at requested quality, quantity, yields and costs, or in a timely manner, our business would be seriously harmed. As a result, we would have to attempt to identify and qualify substitute manufacturers, which could be time consuming and difficult, and might result in unforeseen manufacturing and operations problems. For example, Jabil Circuit, Inc. acquired Varian, Inc. in March 2005 and closed the facility that manufactured our products. We transferred this production to another contract manufacturer. Moreover, as we shift products among third-party manufacturers, we may incur substantial expenses, risk material delays or encounter other unexpected issues.

In addition, a natural disaster could disrupt our manufacturers’ facilities and could inhibit our manufacturers’ ability to provide us with manufacturing capacity in a timely manner or at all. If this were to occur, we likely would be unable to fill customers’ existing orders or accept new orders for our products. The resulting decline in net revenues would harm our business. We also are responsible for forecasting the demand for our individual products. These forecasts are used by our contract manufacturers to procure raw materials and manufacture our finished goods. If we forecast demand too high, we may invest too much cash in inventory, and we may be forced to take a write-down of our inventory balance, which would reduce our earnings. If our forecast is too low for one or more products, we may be required to pay charges that would increase our cost of revenues or we may be unable to fulfill customer orders, thus reducing net revenues and therefore earnings.

Because we depend on international sales for a substantial amount of our net revenues, we are subject to international economic, regulatory, political and other risks that could harm our business, financial condition or results of operations.

The following table presents the amount of revenue derived from international sources (amounts in thousands except percentages) for the periods indicated:

	Six Months Ended
	December 31,
			% of Net				% of Net		$		%
	2005		Revenue		2004		Revenue		Variance		Variance

Americas	$	16,072		63.8%	$	15,994		66.8%	$	78		0.5%
EMEA		6,568		26.1%		6,205		25.9%		363		5.9%
Asia Pacific		2,555		10.1%		1,754		7.3%		801		45.7%
Total	$	25,195		100.0%	$	23,953		100.0%	$	1,242		5.2%

We expect that international revenues will continue to represent a significant portion of our net revenues in the foreseeable future. Doing business internationally involves greater expense and many risks. For example, because the products we sell abroad and the products and services we buy abroad are priced in foreign currencies, we are affected by fluctuating exchange rates. In the past, we have lost money because of these fluctuations. We might not successfully protect ourselves against currency rate fluctuations, and our financial performance could be harmed as a result. In addition, we face other risks of doing business internationally, including:

unexpected changes in regulatory requirements, taxes, trade laws and tariffs;

reduced protection for intellectual property rights in some countries;

differing labor regulations;

compliance with a wide variety of complex regulatory requirements;

changes in a country’s or region’s political or economic conditions;

effects of terrorist attacks in the U.S. and abroad;

greater difficulty in staffing and managing foreign operations; and

increased financial accounting and reporting burdens and complexities.

Our international operations require significant attention from our management and substantial financial resources. We do not know whether our investments in other countries will produce desired levels of net revenues or profitability.

If we are unable to sell our inventory in a timely manner it could become obsolete, which could require us to increase our reserves and harm our operating results.

At any time, competitive products may be introduced with more attractive features or at lower prices than ours. There is a risk that we may be unable to sell our inventory in a timely manner to avoid it becoming obsolete. The following table shows our inventory and excess and obsolete inventory reserve (in thousands) for the periods indicated:

	December 31,			June 30,
	2005			2005

Raw materials	$	3,787		$	3,973
Finished goods		6,731			7,277
Inventory at distributors		1,362			1,181
		11,880			12,431
Reserve for excess and obsolete inventories		(5,256	)		(5,603	)
	$	6,624		$	6,828

In the event we are required to substantially discount our inventory or are unable to sell our inventory in a timely manner, we would be required to increase our reserves and our operating results could be substantially harmed.

If we are unable to attract, retain or motivate key senior management and technical personnel, it could seriously harm our business.

Our financial performance depends substantially on the performance of our executive officers and key technical employees. We are dependent in particular on Marc Nussbaum, our President and Chief Executive Officer, and James Kerrigan, our Chief Financial Officer and Secretary. We have no employment contracts with these executives. We are also dependent upon our technical personnel, due to the specialized technical nature of our business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our key technical personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel might decide to leave, and we might incur increased operating expenses associated with finding and compensating replacements.

If our OEM customers develop their own expertise in network-enabling products, it could result in reduced sales of our products and harm our operating results.

We sell to both resellers and OEMs. Selling products to OEMs involves unique risks, including the risk that OEMs will develop internal expertise in network-enabling products or will otherwise incorporate network functionality in their products without using our device networking solutions. If this were to occur, our sales to OEMs would likely decline, which could reduce our net revenue and harm our operating results.

New product introductions and pricing strategies by our competitors could reduce our market share or cause us to reduce the prices of our products, which would reduce our net revenues and gross margins.

The market for our products is intensely competitive, subject to rapid change and is significantly affected by new product introductions and pricing strategies of our competitors. We face competition primarily from companies that network-enable devices, semiconductor companies, companies in the automation industry and companies with significant networking expertise and research and development resources. Our competitors might offer new products with features or functionality that are equal to or better than our products. In addition, since we work with open standards, our customers could develop products based on our technology that compete with our offerings. We might not have sufficient engineering staff or other required resources to modify our products to match our competitors. Similarly, competitive pressure could force us to reduce the price of our products. In each case, we could lose new and existing customers to our competition. If this were to occur, our net revenues could decline and our business could be harmed.

We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position.

We have not historically relied on patents to protect our proprietary rights, although we are now building a patent portfolio. We rely primarily on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Despite any precautions that we have taken:

laws and contractual restrictions might not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies;

other companies might claim common law trademark rights based upon use that precedes the registration of our marks;

other companies might assert other rights to market products using our trademarks;

policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we might be unable to determine the extent of this unauthorized use;

courts may determine that our software programs use open source software in such a way that deprives the entire programs of intellectual property protection; and

current federal laws that prohibit software copying provide only limited protection from software pirates.

Also, the laws of some of the countries in which we market and manufacture our products offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third-parties to benefit from our technology without paying us for it, which could significantly harm our business.

Business interruptions could adversely affect our business.

Our operations and those of our suppliers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks and other events beyond our control. A substantial portion of our facilities, including our corporate headquarters and other critical business operations, are located near major earthquake faults and, therefore, may be more susceptible to damage if an earthquake occurs. We do not carry earthquake insurance for direct earthquake-related losses. In addition, we do not carry business interruption insurance for, nor do we carry financial reserves against, business interruptions arising from earthquakes or certain other events. If a business interruption occurs, our business could be materially and adversely affected.

If we fail to maintain an effective system of disclosure controls or internal controls over financial reporting, our business and stock price could be adversely affected.

Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to evaluate periodically the effectiveness of their internal controls over financial reporting, and to include a management report assessing the effectiveness of their internal controls as of the end of each fiscal year. As we are currently a non-accelerated filer, current SEC rules will require that our first management report on the effectiveness of our internal controls be in our first fiscal year ending on or after July 15, 2007. These rules will also require our independent public accountant to attest to, and report on, management’s assessment of our internal controls over financial reporting.

Our management does not expect that our internal controls over financial reporting will prevent all errors or frauds. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, involving us have been, or will be, detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by individual acts of a person, or by collusion among two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies and procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to errors or frauds may occur and not be detected.

In connection with our fiscal 2005 audit and described in our Annual Report on Form 10-K filed with the SEC on September 28, 2005, we determined and informed our Audit Committee that we had incorrectly accounted for (i) the accrual of professional fees and other accrued liabilities and (ii) amounts previously recorded as stock-based compensation related to a stock option grant to a terminated employee, which resulted in the adjustment to amounts as originally reported in our first, second and third fiscal quarters of 2005 consolidated financial statements. In addition, we determined and concluded that there were other significant deficiencies in our financial statement close process. We concluded that these conditions were a material weakness in our internal controls over financial reporting. Included in this Quarterly Report on Form 10-Q in Item 4, Part I is a more detailed discussion of the material weakness that has been identified. We have taken steps to remediate the material weakness in our internal controls over financial reporting and the ineffectiveness of our disclosure controls. Our failure to adequately remediate our material weakness could have a material adverse effect on our business, results of operations and financial condition.

We cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our disclosure controls and internal controls over financial reporting in the future. If our internal controls over financial reporting are not considered adequate, we may experience a loss of public confidence, which could have an adverse effect on our business and our stock price.

Changes in the accounting treatment of stock options will adversely affect our results of operations.

In December 2004, the FASB issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values and does not permit pro forma disclosure as an alternative to financial statement recognition. We adopted SFAS 123R beginning in the first quarter of fiscal 2006. The adoption of the SFAS 123R fair value method had a significant adverse impact on our reported results of operations because the share-based compensation expense is charged directly against our reported earnings. Had we adopted SFAS 123 in prior periods, the magnitude of the impact of that standard would have approximated the impact of SFAS 123R assuming the application of the BSM option-pricing formula as described above in the section Adoption of SFAS 123R.

We may experience difficulties in implementing or enhancing new information systems.

We plan to implement a new enterprise resource planning (“ERP”) information system to manage our business operations during calendar 2006. While we do not expect to use the new ERP information system to manage our business during the current fiscal year ending June 30, 2006, the possibility exists that our migration to the new ERP information system could adversely affect our disclosure controls and procedures or our operations in future periods. The process of implementing new information systems could adversely impact our ability to do the following in a timely manner: accept and process customer orders, receive inventory and ship products, invoice and collect receivables, place purchase orders and pay invoices, and all other business transactions related to the finance, order entry, purchasing, supply chain and human resource processes within the new ERP systems. Any such disruption could adversely affect our financial position, results of operations, cash flows and the market price of our common stock.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

The annual meeting of stockholders was held on November 15, 2005. H.K. Desai, Thomas W. Burton, Kathryn Braun Lewis and Howard T. Slayen, all four directors on the board of directors, were elected to serve until the 2006 annual meeting of stockholders. A proposal to ratify the appointment of McGladrey & Pullen, LLP as our independent registered public accountants for the fiscal year ending June 30, 2006 was submitted to the stockholders. There were 49,736,900 votes cast for, 41,650 votes cast against and 3,800 abstentions.

Item 5. Other Information

None

Item 6. Exhibits

Exhibit
Number	Description of Document


31.1	Certification of Principal Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

* Furnished, not filed.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: February 10, 2006
	LANTRONIX, INC. (Registrant)

	By:	/s/ Marc H. Nussbaum

		Marc H. Nussbaum Chief Executive Officer (Principal Executive Officer)




	By:	/s/ James W. Kerrigan

		James W. Kerrigan Chief Financial Officer and Secretary (Principal Financial Officer)

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Lantronix (LTRX) 10-Q2006 Q2 Quarterly report

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